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Monsters Incorporated (MI)is ready to launch a new product.Depending upon the success of this product,MI will have a value of either $100 million,$150 million,or $191 million,with each outcome being equally likely.The cash flows are unrelated to the state of the economy (i.e.risk from the project is diversifiable)so that the project has a beta of 0 and a cost of capital equal to the risk-free rate,which is currently 5%.Assume that the capital markets are perfect.
-Suppose that MI has zero-coupon debt with a $125 million face value due next year.The yield to maturity of MI's debt is closest to:

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The correct answer is A.The yield to maturity of MI's debt is closest to 12.5%. This is because the expected value of MI's future cash flows is $147 million, which is equal to the face value of the debt. The risk-free rate is 5%, so the yield to maturity of the debt must be greater than 5% in order to compensate investors for the risk of default. However, the yield to maturity cannot be too high, or else investors will not be willing to buy the debt. The yield to maturity of 12.5% is a reasonable compromise between these two factors.

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